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High Fund Payouts Can’t Go on Forever
10/21/2011 9:00 am EST
John Heinzl, reporter and columnist for Globe Investor, clears up some of the misinformation about high-return funds.
My recent column about the aggressive distributions of some income funds generated a lot of questions from readers. Many of you are confused and some are fearful of getting hosed by these products.
So today, I’ll respond to your queries. Investors are right to be concerned when a fund consistently distributes more than it makes in interest, dividends, and capital gains, but there is some misinformation out there that needs to be cleared up.
When a fund distributes more than it earns, and it uses investors’ own capital to make up the difference, isn’t that a classic Ponzi scheme?
No. In a Ponzi scheme, new investors are continually brought in to pay the lofty returns promised to existing investors, while the perpetrator of the fraud siphons off money. Ultimately, the scheme collapses when the promoter disappears, the number of new recruits slows or investors start demanding their money back.
This is fundamentally different from a mutual fund that pays out more than it makes. When a cash distribution includes return of capital (ROC), investors are essentially getting a portion of their own money back, and their capital in the fund will fall by a corresponding amount.
However, their units are backed by real assets, and they can redeem them at any time. Unlike a Ponzi scheme, where the money may be tied up in a criminal’s yacht collection or Nigerian bank account.
What do you see happening to the BMO Monthly Income Fund?
For now, BMO says it is under no pressure to cut its distribution. Because most unitholders are reinvesting their distributions, the returns generated by the portfolio are sufficient to pay those who want their distributions in cash.
However, if the fund continues to distribute more than its total return, its net asset value (NAV), or price, will gradually fall. And the distribution will account for a growing percentage of the NAV, making it increasingly difficult for the fund to support the payout.
The distribution "can’t be sustained forever. They will have to cut it," said Dan Hallett, director of asset management for HighView Financial Group.
The timing depends on how the stock market performs—the worse it does, the more pressure there will be on BMO to act.
However, it’s important to remember that, while a distribution cut will have implications for investors who depend on the monthly income, it will have no immediate impact on the NAV of the units. It’s not a house of cards waiting to collapse, which is why I’m not selling my units.
You said ROC has tax benefits. Can you elaborate?
Unlike dividends or interest, ROC is not immediately taxable. Instead, it is deducted from the adjusted cost base of the units, creating a larger capital gain (or smaller capital loss) when the units are sold. So, ROC is essentially taxed at the same preferential rate as capital gains, but the tax is deferred.
You said unitholders who reinvest their distributions won’t see their capital depleted by ROC, but isn’t that like pouring water into a leaky bucket?
No. If you reinvest your distributions in a mutual fund that pays out more than it makes from dividends, interest, and capital gains, ROC is moot. Why? Because you are, in effect, taking the ROC the fund gave you and handing it right back to them.
The result is that the value of your investment will not be affected by ROC; it will rise and fall along with the total returns of the fund. Only if you are taking the ROC in cash will your capital "leak."
Why would you own three different monthly income funds? This sounds like a bad case of overdiversification.
I use these funds to "sop up" stock dividends in different accounts, for different reasons. The RBC Monthly Income Fund has the lowest management-expense ratio (MER), at 1.18%, but sadly, it’s not eligible for registered accounts, so I use it in my non-registered account.
For smaller accounts that generate less dividend income (TFSA and RESP), I use the BMO Monthly Income Fund, because, as a BMO InvestorLine customer, I can contribute as little as $50 to any BMO fund.
For my RRSP, which generates more dividend income, I have for years been using the TD Monthly Income Fund, which has a $500 minimum purchase with my broker. Aren’t you glad you asked?
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